Reinsurance Structures, Pro Rata Pricing, & When Good Pricing Goes Bad August 8, 2007

2 Proportional Reinsurance Structures Straight Quota share- cede a percentage of losses for an identical percentage of premium. If the commission paid is commensurate with insurers costs, there is an alignment of interests. 1. Used to reduce premium writings relative to surplus 2. Generate commission overrides to offset expense and increase profit Surplus Quota Share- A form of proportional reinsurance where the reinsurer assumes pro rata responsibility for only that portion of any risk which exceeds the company’s established retentions. May promote writing larger limits compared to historical experience Promote writing riskier or more volatile business Variable Quota Share – insured cedes different percentages of business depending on the limit – 0% of 5 M limit, 50% of 10 M limit, etc. Essentially, this can be viewed as a variable quota share contract wherein the reinsurer's pro rata share of insurance on individual risks will increase as the amount of insurance increases, given the same reinsurer's retained line, in order that the primary company can limit its net exposure to one line, regardless of the amount of insurance written 1. May promote the writing of larger or more hazardous risks going forward 2. Encourage reducing limits on more profitable business to improve net results

3 Commission Override Example

4 Non Proportional Reinsurance  Excess of Loss Flat Rated Can be appropriate when there is a standard limit and little variability in insured groups If limits vary, a flat rate may promoted more hazardous writing and large limits Cessions Rated Better when there are a variety of limits or various hazards ceded  Facultative Individual risks – usually priced at higher profit margins than treaty business. Obligatory – most similar to a treaty  Non-Obligatory Can be used with many types of reinsurance. It means that the insured can pick what risks it wants to keep and cede the rest.  Stop Loss A form of reinsurance under which the reinsurer pays some or all of a cedant’s aggregate retained losses in excess of a predetermined dollar amount or in excess of a percentage of premium Often significant adverse selection against reinsurers on these covers as the cedents have a better sense of the ultimate gross loss ratio than the reinsurer Almost always includes a loss ratio cap May have risk transfer issues

5 Basics of Pricing  Components  Losses Paid/Reported Paid Losses– trend issues Reported Losses – Reserve issues Large Losses Cat Losses Claim Counts Triangulations of Losses  Exposure Data Payroll Sales Square Footage Premium Doctors – Base Doctor Equivalents

6 Adjustments  Loss Development  Trend – Severity/Frequency  Premium On Level Adjustments  Exposure Adjustments  Adjustments for Limits and Attachment/SIR Changes  Loading for catastrophe  Free cover  Load for ECO/XPL  Summing claims for basket or aggregate cover  Load for Clash  Tort Reform adjust trend adjust loss development Is tort reform retroactive?

7 Loss Development Selection Incurred Losses - PY3 Months15 Months27 Months39 Months51 Months63 Months75 Months87 Months99 Months ,776 2,543,415 3,706,515 4,070,948 4,589,893 5,635,622 6,232,223 7,104,451 7,910, ,265 3,063,379 4,439,324 4,952,021 5,210,846 5,184,224 5,678,068 5,849, ,366 8,322,590 15,339,602 15,691,784 15,903,253 15,888,604 16,115, ,280 8,189,697 16,424,303 18,293,479 20,109,521 20,102, ,477 8,773,920 24,078,043 28,048,880 23,673, ,908 8,748,828 16,251,552 16,401, ,959 7,353,855 10,415, ,988 10,820, , Strt Average Tail Factor Wtd Average NCCI AY Selected Ultimate

8 Umbrella Quota Shares use Excess Trend Ground up 500, ,000 Loss 1 100, , , , , , , , , , ,000 Total 1,800,000 1,890, , ,000 Overall trend5%Excess trend18%

9 Excess Losses Deductibles and Layering

10 On Leveling Premium  Rate On Level Factors  Parallelogram method or Premium at Present Rates  Premium/Exposure Trend  Yes if exposure base is inflationary insured value Sales revenues  No if exposure base is square feet # vehicles # employees # doctors – should consider translating into base doctor equivalents  Trend from:  Average accident date of experience period to average accident date of prospective period

11 On Leveling Premium Rate Changes should consider changes to base rates, schedule credits and debits, tier rating, LCMs. They should also be adjusted for changes in limits and attachment points on the underlying policies. Parallelogram method uses geometry to calculate on level factors. Premium at Present Rates re-rates all historical policies using prospective rates. Minimum Premiums can have a significant impact on rates. The impact is negative when rates are rising and positive when rates are falling. In a rate environment where rate increases have been significant the last few years the actual on level will be overstated.

12 Actual Calculation for On Level Factor

13 Shifting Distributions and On Level Factors

14 WC On Level Example

15 Change in Average Premium

16 Losses Occurring with Run-Off  Distortion to On – Level Factors if rates are decreasing 1/1/05 12/31/05 12/31/06 UEP = 1/3 of Treaty Premium

17 Risks Attaching with Cut-Off  Distortion to On – Level if rates are increasing 1/1/02 12/31/02 12/31/03 UEP = 1/2 of Treaty Premium

18 Premium On Level Adjustments Written Premium RenewalExpiringRateActualSubmission Policy IncreaseOn Level ,527, ,04463% ,748,682 2,066,04081% ,740,033 3,191,74417% ,455,287 3,205,0478% ,021,483 1,807,09612% ,750,713 1,567,78912% % 1.00

19 Limits/Attachments Adjustments  When a company’s limits and attachments have shifted, adjustments must be made to the analysis!  Trend past historical limits – this will underestimate your costs if the losses were truncated. Only works if the policy limits have adjusted due to inflation.  Price lower “fully exposed” layer and use exposure rating relativities to adjust to current layer. This approach is easiest if everything is fully exposed. If there are few losses in the layer, you need to convince yourself that the experience is not credible.  Adjust using exposure rating differential based on limits distribution profile in each year  Calculate a loss distribution based on current experience and run against new limits  Attachments shifting downwards are the easiest to adjust for by subtracting old attachment out after trending and adding new attachment

20 Pricing for Contract Provisions  Multi-Year Policies- Need to consider the impact on trend and development for multi-year policies Impact on the risk of a deal where your exposure now extends several years.  Funding Requirements – this is generally ignored in pricing but shouldn’t be Requirement when rating or surplus drops or reinsurer stops writing new business. Companies that agreed to these provisions found themselves quickly out of business when there rating dropped. Some Surety deals require funding at every 12/31 This usually require and LOC and this cost should be priced into the business  Errors & Omissions clauses covering business excluded by the treaty if bound accidentally.  Ex Gratia payments – anyone dealing with a large insured may find themselves paying claims just to keep them happy. If the deal is marginal to begin with, this would eliminate some of the expected profit.  Some swing rated treaties allow for losses to be deemed $0 and pay only the minimum. It is important to look at the NPV of the deal in all situations and realize that the client will act to maximize that. The end result is that the likely outcomes will be minimum premiums until you are in a loss position.

21 Select Projected Loss Cost  Select for Stability?  Have there been changes in the writings.  Tort Reform  Select for Responsiveness?  Recent years effected by large development factors  Mature years may be over trended or rate changes may be overstated.  What if a company renews 60% of the book each year?  Somewhere in the middle?

22 Selecting Loss Costs

23 Selecting Ultimate Loss & LAE Costs

24 Adjusting For Free Cover

25 Other Considerations  “As If”  A term used to restate the treaty statistics for prior years to accord with the current (or proposed) limits, terms and conditions Sometimes also used to show results as if exceptional losses had not occurred. 1. “As If” – short for “As If I only wrote profitable business” 1. Exclude line of business no longer written  Does it exclude both losses and premium?  Did it also impact the rate changes as well? 2. Exclude these losses since they are excluded from the treaty. There are always exposures not included and there will always be exposures included now but not included in the future. 3. Excludes Underwriter “F” 4. Current insureds only – BEWARE – this is an “as if” in disguise 5. Do you get to exclude future losses from business they will decide to get out of next year? If not, beware of “as if” results. 2.

26 Another “as if”  “as If” I wrote the same distribution  This is harder to dispute since the basis is well grounded in actuarial science. Take the historical losses and premium and adjust it to the current exposures written. If the book was predominantly GL and now it is predominantly products we should adjust the mix to the current business mix. If the book is predominantly Texas historically and is currently Missouri we should adjust the historical state experience to match the current mix.

27 State Distribution Mix

28 Pricing New Business – Start Ups  The class of “2001” created several insurance and reinsurance start ups. Many of these companies wanted reinsurance and had no experience. For them the “clean slate” was a plus. What information is available to price start up. Similar treaty business – Can this treaty perform significantly better than established books of similar business? New business is bought with cheaper prices Benchmarking Rate comparisons Overall industry experience Stat Bulletins – NCCI, ISO One Source – Annual Statement Data Broker or Trade Group Studies External or Internal actuarial rate studies Pricing hurdles for start ups. Return requirements – should they be higher? Execution risk Different structure for a start ups – lower cede, loss ratio cap, loss corridors or sliding scale commission  What happens when the only business you write in a line are start ups? Time to question the pricing assumptions